'Beneficial owner': 2014 update to the OECD commentary

In
parallel to work on the BEPS project, the OECD has sought to clarify the
meaning of 'beneficial owner' in a tax treaty context. Dan Foster considers the 2014 Update to the
Commentary.

The
Council of the Organisation for Economic Co-Operation and Development (OECD)
approved the 2014 Update to the Model Tax Convention (MTC) and Commentary on 15
July 2014.

The update includes the
outcome of the revised proposals concerning the meaning of "beneficial
owner", issued as a discussion draft on 19 October 2012, and approved in
its final form by the OECD Committee on Fiscal Affairs on 26 June 2014. A consolidated version of the OECD MTC and
Commentary incorporating the 2014 Update was published on 5 September 2014.

The OECD Model Tax Convention

The
OECD MTC proceeds on the presumption that a contracting state will rightly seek
to tax the worldwide income of its residents.
The MTC recognises, however, that the state of source should retain
taxing rights to certain types of income arising within its borders. The so-called 'distributive' articles of the
MTC are consequently divided into three categories:

Article
15 - Short-term employment in the private sector (and remuneration not paid or
borne in the source state)

Article
18 - Private pensions

Article
20 - Students

Article
21 - Other income (other than with respect to a permanent establishment)

Article
22 - Capital (other than immovable property)

Any
residual double taxation that is not relieved by the distributive articles may
be eligible for exemption or credit in terms of Article 23 or in terms of
domestic law.

It
is important to note that tax treaties negotiated by states may differ
significantly from the model outlined above.

Treaty relief for dividends, interest
and royalties

As
will be recognised above, interest and dividends may be taxed in the source
state, but such taxing right is not unlimited.
In terms of the MTC, the source state's right to tax is recommended to
be capped at between 5 percent and 15 percent of the gross income (depending on
the circumstances), while the state of residence retains unlimited taxing
rights.

Royalties,
on the other hand, may only be taxed in the state of residence and must be
exempted from tax in the source state, in terms of the MTC. In practice, however, many tax treaties
provide for limited taxation of royalties in the source state, in the same
manner as for dividends and interest.

The
maximum rates of source state taxation in a selection of South Africa's tax
treaties is summarised in Table A.

Table A

Treaty with:

Dividends (15%) (qualifying companies)

Interest

(15% WHT to be introduced from 2015)

Royalties

(15% from 2015)

United Kingdom

5%

0%

0%

Mauritius

5%

0%

0%

Cyprus

0%

0%

0%

Italy

5%

10%

6%

Australia

5%

10%

10%

India

10%

10%

10%

The 'beneficial owner' test

Importantly,
the relief from source state taxation provided for by the MTC is only available
if the "beneficial owner" of the dividend, interest or royalty is
resident in the other contracting state.
This test is incorporated into most of South Africa's tax treaties.
Notably, the MTC does not automatically provide relief based on where the immediate
recipient of the payment is resident, since the recipient and the beneficial
owner may be different persons. Where
the beneficial owner of the income is not a resident of the other contracting
state, the source state's right to tax is not
limited. In other words, if the
beneficial owner is not resident in the other treaty state, the source state
may subject the income to taxation in full
according to its local laws and need not apply any exemption or reduced rate of
withholding afforded by the tax treaty.

The
updated Commentary retains the interpretation that a nominee, agent or
"conduit company" will not be the beneficial owner of the income paid
and received, and the source state may consequently deny relief if the
immediate recipient is resident of the other state, but the beneficial owner is
not.

Consequently,
the "beneficial owner" test has been the subject of considerable
debate, and even litigation, in many countries. At
the root of the debate is the lack of a definition for "beneficial
owner" in Article 3(1) of the MTC, or within Articles 10, 11 or 12. Normally, this would mean that, in terms of
the so-called "Renvoi
clause" of Article 3(2), the phrase would take its meaning from the
domestic laws of the state applying the treaty (in other words, the state
giving up its taxing rights, being the source state in this instance). The OECD MTC Commentary ("the
Commentary") notes, however, that the phrase is "not used in a narrow
technical sense" but rather it should be understood in its context and in
light of the object and purpose of the MTC, being the elimination of double
taxation and prevention of fiscal evasion.
This rule of interpretation is in keeping with Article 31(1) of the Vienna Convention on the Law of Treaties,
and the principles laid down in the Commerzbank
and Memec cases, so is not
necessarily at odds with the Renvoi
rule. This approach was also confirmed
by the South African Appeal Court (as it then was) in the Mango case, which found that treaties should not be strictly
interpreted using ridged domestic rules of construction. A potential conflict therefore arises with
respect to the definition of "beneficial owner" in section 64D, which
is discussed below. Although
no South African court has ruled on the issue, it has been considered at length
by foreign courts.

The Velco case

On
24 February 2012, Associate Chief Justice EP Rossiter of the Tax Court of
Canada handed down judgement in Velcro
Canada Inc. v Her Majesty the Queen.
The ruling extended the approach taken to "beneficial owner"
in the earlier Prevost case, finding
that the Dutch recipient of royalties retained the attributes of beneficial
ownership, namely "possession, use, risk and control", despite having
a contractual obligation to pay 90 percent of such royalties to a subsidiary in
the Dutch Antilles within 30 days. Canada's
source state taxing rights were therefore limited to 10 percent (and 0 percent
from 1998) in terms of the Canada-Netherlands tax treaty, rather than the full
25 percent which would apply to a resident of a non-treaty state such as the
Dutch Antilles.

Importantly
in this case, there was no "pre-determined flow of funds" since the
royalties were inter-mingled with the Dutch company's own funds (in other
words, not segregated), used for various commercial purposes during the 30
days, and were exposed to creditors of the Dutch company while in its account. The Dutch company could not bind the Antilles
company, and acted on its own behalf, so was not an agent or nominee. Furthermore, the Dutch company was not a
"mere channel" with no discretion as to the use of the funds, and was
therefore not a so-called "conduit company". The court found that it
could not "pierce the corporate veil" of the Dutch company unless
that company had absolutely no discretion with respect to the funds received.

The
case highlighted the appropriate tests for beneficial ownership of income, and
has been the touchstone for tax treaty interpretation of the term over the past
few years.

The 2014 update to the commentary

The
present update to the Commentary on "beneficial owner" focuses on three
main issues:

i) The use of an autonomous versus a domestic meaning of the
concept of "beneficial owner";

ii) The obligations, facts and circumstances that may impact the
determination of the "beneficial owner"; and,

iii) Considerations applicable to so-called
abusive arrangements.

With
regards to i), the Commentary notes that the term "beneficial owner"
is specifically used to identify the person eligible for treaty relief when an
amount is "paid direct to a resident" (as paragraph 12 of the Article
10 Commentary now reads) and should be interpreted in that context. The existing caution against using a
technical meaning from domestic law is further emphasised, particularly with
reference to common law countries where the term has a specific meaning under
trust law. Such meaning should be
ignored for treaty purposes - for example, the trustees, or the trust (if a
separate taxpayer), can be the "beneficial owners" of the income even
if it does not vest in beneficiaries, despite that term not being appropriate
for trustees in a domestic trust law context.

The
caution against using a domestic definition in a treaty context would also
apply to our section 64D, where "beneficial owner" means "the
person entitled to the benefit of the dividend attaching to a share". This definition would apply in the
application of the Dividend Tax, but not in the determination of entitlement
for treaty relief (in other words, a reduced rate of withholding). In practice, however, the two considerations
are inextricably linked, but fortunately in this case not incompatible. Until one or both definitions are considered
by our courts, there appears to be no risk in assuming they refer to the same
person. That is, a beneficial owner for
treaty purposes will be the beneficial owner for Dividend Tax purposes, and vice versa. It is also submitted that,
as there is no obvious conflict between the defined term and the treaty term,
the inclusion of the relevant treaty term in domestic law, via section 108,
does not create a situation where we must determine if the treaty over-rides
section 64D. It is also clear that the
section 64D definition is not particularly "narrow" or
"technical", but rather reflects the "ordinary meaning",
which is compatible with both domestic and treaty rules of interpretation.

The
Commentary further notes that a meaning ascribed to "beneficial
owner" for the purposes of, for example, identifying individuals who
exercise "ultimate effective control over a legal person or
arrangement" is not appropriate to the context. The Commentary also emphasises that the
beneficial owner of the dividend is
being tested "as opposed to the [beneficial] owner of the shares, which
may be different".

With
regards to ii), the Commentary, at paragraph 12.4 of Article 10, confirms that
the existing examples ("agent, nominee, conduit company acting as a
fiduciary or administrator") are not beneficial owners since they are
constrained by a contractual or legal obligation to pass on the payment to
another person and "on the basis of facts and circumstances… in substance…
do[es] not have the right to use and enjoy the dividend unconstrained" by
such obligations. This statement can
arguably be distinguished from the facts of the Velcro case, discussed above.
Notably, references to "related" and "unrelated"
obligations appearing in the 2012 discussion document have been omitted from
the final Commentary and replaced with: "This type of obligation would not
include contractual or legal obligations that are not dependant on the receipt of the payment…" [my
emphasis]. In this context, the
Commentary further notes that financial arrangements such as pension and
collective investment schemes would generally qualify as beneficial owners.

Another
important aspect of the 2014 Update is the Commentary on abusive arrangements at
paragraph 12.5 of Art. 10 (point iii) above).
While confirming the OECD's general stance on abuse of tax treaties
(they are against it, unsurprisingly), the Commentary states that the
"beneficial owner" provision targets a specific type of arrangement
("in other words, those involving the interposition of a recipient who is
obliged to pass on the dividend to someone else"), and is not meant to be
used to counter "treaty-shopping" generally. Other approaches to counter general treaty abuse
are recommended, namely limitation of benefits ("LoB") clauses, as seen
in South Africa's treaties with Japan and the US, and substance-over-form
challenges (as available under South African common law).

Impact in South Africa

Taxpayers
and advisors must be alert to the new Commentary with respect to the
"facts and circumstances" which are relevant in the determination of
the "beneficial owner" of cross-border income flows, particularly
where a resident has an obligation to pass on the income to another person in a
non-treaty state. While the Commentary
confirms the "right to use and enjoy" the dividend as a pre-requisite
of beneficial ownership, there may be a very fine line between acceptable
arrangements (as the Canadian court found in Velco) and unacceptable arrangements as contemplated by the OECD.

If
a South African court were asked to consider the application of, say, the OECD
Commentary on "beneficial ownership" as opposed to the Velco interpretation, two important
considerations would arise:

i) the
status of the OECD Commentary in South African law; and

ii) the
status of foreign case law in treaty interpretation.

Volumes
have of course been written on this topic, which I shall not add to here except
to note the following:

Section
232 of the Constitution states that customary international law is the law in
South Africa unless it is inconsistent with the Constitution or an Act of
Parliament. For various reasons, this only
gets us so far (What is included in customary international law? What qualifies
as inconsistent?)

Section
233 of the Constitution, more helpfully, states that "when interpreting
legislation, every court must prefer any reasonable interpretation of the
legislation that is consistent with international law over any alternative
interpretation that is inconsistent".
But again, is international law the Commentary, or foreign judgements?

While
SIR v Downing would appear to give
persuasive weight to the OECD Commentary, that court's ruling was not in fact
based on such Commentary, and merely recognised that an international guide to
fiscal interpretation did exist.
Furthermore, the main reference to the Commentary was made by the Natal court
(not the Appeal Court) and is therefore of little precedent value.

"A treaty must be interpreted in good faith in accordance with the
ordinary meaning to be given to terms of the treaty in their context and in
light of its object and purpose"

Article
32 goes on to state that recourse may be had to supplementary means of
interpretation "including preparatory work of the treaty", in order
to confirm the meaning resulting from the application of Article 31(1) above
(which would include an analysis of the context, object and purpose). Supplementary material would also be
appropriate if the meaning is ambiguous or obscure, or the result is manifestly
absurd or unreasonable.

Although
"preparatory work" of the treaty is kept secret in South Africa, it
is reasonable to assume that part of National Treasury's preparation for treaty
negotiations involved consulting the OECD MTC and Commentary. South Africa's tax treaties are, after all,
based on that model. In the celebrated Smallwood case, the UK Special
Commissioners noted, when considering the UK-Mauritius tax treaty, that
"the negotiators on both sides could be expected to have the Commentary in
front of them" and "can be expected to have intended that the meaning
in the Commentary should be applied in interpreting the Treaty when it contains
identical wording". Even in Smallwood, however, the court was not
helped by the Commentary, which it said merely confirmed the extent of the controversy
under consideration (namely, "place of effective management").

We should also be conscious of the judgement
of the UK Court of Appeal in the Memec
case, which noted that commentaries, and decisions of foreign courts, have
persuasive value only, and in any case their use in interpretation is
discretionary rather than mandatory.

The OECD Commentary has been routinely
referred to by the UK courts since at least 1984, but the lack of
treaty-related cases in South Africa leaves it untested here. In the UK, HMRC's International Tax Manual states that the Commentary may be used as
an aid to interpretation, while SARS has issued no such guidance.

The Commentary is largely the work of
officials from OECD revenue authorities and finance ministries, and not
necessarily drafted as an impartial guide for taxpayers. In this respect, it may be considered mere
"expert opinion" on par with other commentators and indeed foreign
judges.

As
Judges Avery Jones and Sadler noted in the FCE
Bank case, it is indeed not uncommon for courts in OECD countries to rule
contrary to the OECD Commentary applicable to their own states. The Commentary in fact played no part in the
subsequent Court of Appeal ruling on the FCE
Bank matter. So why should a
non-OECD state put more faith in the Commentary than in foreign judgements of
superior courts?

Until
such time as a South Africa's Supreme Court of Appeal rules on the meaning of
"beneficial owner" we may, it is submitted, give equal weighting to
both Velco and the Commentary. This does not get us far, admittedly, but I
would be cautious to place a heavier weighting on the Commentary, and neither should
we ignore it completely.

This article first appeared on the January/February edition on Tax Talk.

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